4 6: Determine and Dispose of Underapplied or Overapplied Overhead Business LibreTexts

At the end of the accounting period, the balance (whether it’s underapplied or overapplied) is usually cleared out to zero by adjusting the cost of goods sold or other relevant accounts. This way, the effects of under- or overapplying overhead do not carry forward into future accounting periods. The exact method for dealing with underapplied or overapplied overhead can depend on the specific accounting policies and practices of the company. Since overhead costs contribute to the production of inventory and are incurred throughout the production process, they must be allocated to each job.

Underapplied Overhead vs. Overapplied Overhead

Advanced cost accounting software, such as QuickBooks and Microsoft Dynamics, can automate the tracking of overhead costs and provide real-time insights into cost variances. These tools enable companies to quickly identify and address discrepancies, reducing the likelihood of significant overapplied overhead at the end of the accounting period. Additionally, regular training and development for accounting staff can ensure that they are equipped with the latest knowledge and skills to manage overhead effectively.

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Overapplied overhead is the result of the manufacturing overhead costs that are applied to the production process is more than the actual overhead cost that actually incurs during the accounting period. Underapplied overhead occurs when a business doesn’t budget enough for its overhead costs. This means the budgeted amount is less than the amount the business actually spends on its operations. For example, when a company incurs $150,000 in overhead after budgeting only $100,000, it has an underapplied overhead of $50,000.

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In this case, the manufacturing overhead is underapplied by $1,000 ($11,000 – $10,000) as the applied overhead cost is $1,000 less than the actual overhead cost that has occurred during the accounting period. This journal entry is the opposite of the overapplied overhead as the remaining balance of the manufacturing overhead, in this case, will be on the debit side at the end of the accounting period instead. Hence, we need to credit the manufacturing overhead account instead to zero it out. On the other hand, the company can make the journal entry for underapplied overhead by debiting the cost of goods sold account and crediting the manufacturing overhead account.

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This can affect a company’s perceived financial health and may influence decisions related to pricing, budgeting, and resource allocation. Because accountants have to charge expenses as they’re incurred, manufacturers don’t have the luxury of waiting until the end of an accounting period to determine their exact manufacturing overhead costs. Instead, they start with estimates based on past experience and their expectations for the future. A company might estimate that for the coming year, it will have manufacturing overhead of $250,000 and it will run its machines for a total of 13,000 hours. Underapplied overhead occurs when a company has overhead costs greater than its budgeted costs.

6 Determine and Dispose of Underapplied or Overapplied Overhead

Even though overhead doesn’t affect cash flows, it still shows up in the bottom line or net income. Most managers want to be able to show a profit even after overhead expense, so an estimated amount of overhead is applied for each period. After this journal entry, the balance in the manufacturing overhead account will be zero as it should be our goal to make it zero at the end of the accounting period. Advancements in electronic inventory and production management systems have greatly eased the burden of comprehensive operational reporting, often including underapplied overhead analysis. For example, the manufacturing company ABC finds that it has a $2,000 debit balance of the manufacturing overhead at the end of the accounting period. Understanding how to manage overapplied overhead ensures accurate financial reporting and helps maintain budgetary control within an organization.

• While overapplied overhead occurs when allocated costs exceed actual costs, underapplied overhead is the opposite scenario, where actual costs surpass the allocated amounts.
• Addressing underapplied overhead involves adjusting journal entries to increase COGS and inventory values, thereby aligning them with actual costs.
• Overapplied overhead happens when the estimated overhead that was allocated to jobs during the period is actually more than the actual overhead costs that were incurred during the production process.
• Hence, we need to make the journal entry for the overapplied overhead of $500 by debiting that amount into the manufacturing overhead account to zero it out.

This usually happens when a business uses a standard long-term overhead rate that is based on the average amount of factory overhead that is likely to be incurred, and the average number of units produced. In some periods, either the number of units produced will be greater than expected, or actual factory overhead costs will be lower than expected. In these situations, the use of a standard overhead rate will result in overapplied overhead. For example, on December 31, the company ABC which is a manufacturing company finds out that it has incurred the actual overhead cost of $9,500 during the accounting period. However, the manufacturing overhead costs that it has applied to the production based on the predetermined standard rate is $10,000 for the period. Sometimes, the actual overhead costs for a given period might be lower than what was estimated and allocated to the cost of goods or services, resulting in what is known as overapplied overhead.

The machine shop estimates that its overhead will be $1,000 a month for next three months. After the quarter has ended, it turns out that total overhead incurred for the get to know california income tax brackets last three months was $3,600—not $3,000. Now the machine shop has to book an additional $600 of overhead expense because the original estimate what under applied.

Many businesses book estimated overhead amounts every week or month to evaluate the profitability for the period. For another example, assuming the actual overhead cost that has occurred during the period is $11,000 instead while the applied overhead cost is $10,000, the same as the above example. This journal entry will remove the remaining balance of $500 in the manufacturing overhead account in order to reflect its actual cost of $9,500. Likewise, after this journal entry, the balance of manufacturing overhead will become zero.